As Irish banks face a rise in bad debts and a rise in the cost of capital, Finance Correspondent,  Simon Carswellquestions a bullish dividend plan.

THE PLETHORA of figures released this week, particularly from the State's largest bank, AIB, told one significant story - the economic downturn is biting much more quickly than predicted.

At its half-year results on Wednesday, AIB cut its earnings target for this year, saying it would fall by up to 10 per cent - 11 weeks after predicting a slight increase. The consensus among analysts is for a 14 per cent fall. AIB blamed rising debts, higher funding costs and a tougher economic climate.

AIB's shares rose 6 per cent after the results but were still down 4 per cent over the week.

The bank's exposure to rising bad debts attracted the most attention in its first-half figures.

Loans on watch surged €3.5 billion to €10.2 billion in the six months to June 30th. The rapid decline started in May and the bank has noticed "a very significant drop-off" in mortgage lending since then. AIB chief executive Eugene Sheehy said "criticised loans", which were not delinquent or destined to go bad but risky, had not "caught the eye" before, as they had not grown as quickly.

Most of the increase was due to concerns about loans to Irish residential property developers who are struggling to complete sales amid falling property values and higher mortgage rates. Property and construction loans account for 37 per cent of AIB's €132 billion customer loan book.

Mr Sheehy confirmed AIB was "rolling up" interest payments for some developers. He added that it would be "a total waste of time" forcing them to sell their properties in a market with no buyers.

"We are taking a view that this will be a longer, slower issue over the next couple of years and it will require firm resolve but a lot of patience and understanding."

Speaking at Bankcentre in Dublin 4, Sheehy said the number of clients on rolled-up interest was "not a huge number" because it was still early in the cycle.

The following day, Mark Duffy, chief executive of Bank of Scotland (Ireland) (BOSI), revealed slower profits for its half-year. The reasons were similar to AIB - funding costs, bad debts and a declining economy. BOSI said it was seeing "stress at higher levels" particularly among housebuilders.

Both banks showed far fewer problems with their mortgages.

Despite the recent rush for deposits in the banking sector, AIB saw no deposit growth in the Republic, though deposits grew 9 per cent across the group. BOSI lost €800 million in deposits, blaming increased competition.

It was no surprise that Mr Duffy said property developers will see more pain in the coming months.

An oversupply of unsold property means that house completions are likely to fall to 45,000 this year and 30,000 next year, said NCB Stockbrokers, from 78,000 last year. Sheehy was more pessimistic, predicting 25,000.

The sharp fall has fuelled the concerns on bad debts. AIB said they would reach 0.6-0.8 per cent of loans next year, as property values fall 30-40 per cent from their peak. On the back of AIB's results, NCB cut its earnings forecasts for the Irish banks for 2009, saying they would fall 34 per cent.

The firm said that although it was too early to tell whether any Irish bank would need to raise capital due to increasing bad debts, it would be "prudent" for AIB, Bank of Ireland and Irish Life Permanent "to consider cutting dividends to bolster capital positions".

Goodbody analyst Eamonn Hughes expects AIB to raise its dividend by 4 per cent this year but to reduce it by 30 per cent next year.

AIB surprised some commentators by increasing its interim dividend by 10 per cent this week in a show of confidence to the market.

The bank even factored a similar dividend increase into its worst case scenario in which bad debts would total €4.9 billion between 2008 and 2011 with no loan growth. The bank said that, even with this, it would still have strong capital and would not need to resort to a rights issue.

On Thursday Bank of Ireland said it had raised £450 million (€572 million) of lower tier 2 debt - a capital buffer required by regulators to protect against unforeseen losses - paying an annual interest rate of 9.25 per cent, far higher than the rates last year.

Scott Rankin, analyst at Davy Stockbrokers, said that all banks were paying more for capital in recent months but that the market was "exacting an Irish premium".

In this context, AIB's plan to keep raising dividends must be questioned, particularly if bad debts spike above its targets, as most analysts believe will happen.